The high-yield market has recovered nicely from the corona-induced market crash, but further price appreciation is becoming increasingly unlikely, says manager Ulrich Gerhard of the BNY Mellon Global Short-Dated High Yield Bond Fund in an interview with Investment Officer.
‘Further price rises are increasingly difficult to achieve in this market environment,’ says Gerhard. ‘To the contrary, the increasing tensions around Brexit in particular are increasing the likelihood of a market correction. As the UK attempts to renege on its withdrawal agreement with the EU, the likelihood of volatility is increasing. I don’t expect a new sell-off, but a correction of around 5% is quite possible,’ says London-based Gerhard.
But Gerhard’s fund is already prepared for this: the fund manager has increased his cash position to 6.2% at the end of August due to a lack of attractive investment opportunities. ‘So as soon as the market slows down, we can use that cash to buy more cheaply,’ he says.
Casinos
Other high-yield managers are more optimistic about the short term. For example, Mike Della Vedova of T. Rowe Price said in a market outlook last week that he sees a lot of potential in recovery trades in sectors such as autos and casinos.
But Gerhard is sceptical. ‘It is true that there is a V-shaped recovery, which improves prospects for many companies. But the right side of the V will be lower than the left side, and it will remain that way for some time to come. Until there is a reliable vaccine, economic activity will not reach pre-crisis levels.’
Some credits may seem cheap because spreads are higher than before the crisis, but they are not cheap enough to compensate for the higher risk, Gerhard says, giving car rental company Europcar as an example. ‘They went bankrupt last week, but their bonds are still trading at 40 cents against the dollar. Is that cheap enough? I think the prices of investments in companies that are largely dependent on tourism are very difficult to justify at the moment.’
Economic misery is trickling further down the chain. Small, often unlisted suppliers to large multinationals, a large category in the high yield-sector, are now also facing difficulties. ‘I just spoke to a major player in the oil and gas industry, and they told me they are demanding unconditional price reductions from their suppliers. These big companies know their suppliers often have no alternative, so they usually agree to renegotiate. And new, lower prices will then usually apply for several years to come.’ This, of course, negatively affects these companies bottom-lines.
Tesla
Companies in cyclical sectors that are sensitive to the economic downturn are of course affected most. Therefore secular growth companies such as Tesla have been grown into investor darlings this year. But not for Gerhard, who believes companies should finance growth with equity rather than with debt. ‘If the cash flow minus a company’s investments is negative, that’s a red flag for us,’ says Gerhard.
Because of their high investment outlays, growth companies often do not qualify for inclusion. ‘I don’t like lending money to growth companies. There are plenty of examples of companies that financed their growth with debt, for things to then go completely wrong.’
In this context, Gerhard mentions the British car manufacturer Jaguar Land Rover. ‘They had a growth strategy and in recent years have invested heavily in building new factories and increasing capacity. That all seemed to be going well, until sales in China suddenly collapsed. Then Covid-19 arrived and now there’s also the threat of a hard Brexit.’
Bond investors in competitor Tesla also need strong nerves. ‘A while back, Tesla bonds traded well below intrinsic value,’ says Gerhard. ‘Is a coupon of 5.3% sufficient if a bond can fall as sharply in price as Tesla did?’
That is why Gerhard demands a much higher coupon to compensate for this higher risk in growth companies, but this is usually not being paid. ‘An equity investor is compensated by the upside in the share, but a bond investor isn’t.’
Positive cash flow
So what kind of companies does Gerhard find attractive? ‘In principle, my fund only invests in bonds that need to be refinanced within 12 to 24 months. For me, the long-term prospects for a company are not very relevant; what matters most to me is that a company has a positive cash flow so that it doesn’t need to take on additional debt all the time.’
An example of a company that has evolved from a cash burner to a profitable company is Netflix. ‘Until recently, it burned a lot of cash, but thanks to the coronavirus crisis, among other things, it has gained an enormous number of subscribers, while spending has remained the same. As a result, they suddenly make a profit. It is possible that at some point Tesla will also be able to finance its investments with car sales. If that happens, I could invest in them too.’
Repeat investor
Despite the short investment horizon of his fund, Gerhard does call himself a long-term investor. ‘We talk to the companies we invest in every 10 or 12 days. Then we ask them not only about their cash position, but also about the market environment, customer behaviour, cost savings, whether they make use of government reductions in working hours, and so on.’
Companies are willing to share all that information because his fund likes to be a repeat investor, says Gerhard. ‘We regularly invest in about a third of the companies in our portfolio. We often reinvest the income from a bond in another bond of the same company after a bond matures.’
The dollar-denominated BNY Mellon Global Short-Dated High Yield Bond Fund has a year-to-date return of -1.46% on 11 September. Over the past three years, the total return has been close to 9%. Despite the recent fall in the euro exchange rate, the 3-year yield in euros is still slightly higher at 10.2%.